China logisitcs: Cool customers

It is generally accepted that Yum Brands has created one of the most sophisticated cold chain systems in China. Yum is the country's largest foreign restaurant operator by sales, with 6,243 KFC, Pizza Hut and Taco Bell outlets at the end of 2013. This network is supported by infrastructure that ensures the chicken used in KFC wings reaches quality and safety standards. The company sources products from around 650 suppliers and owns most of a distribution system that includes 20 logistics centers.

But at the end of last year Yum was hit by a supply chain malfunction. In late 2012 it emerged that some suppliers had injected unsafe amounts of growth hormones and antiviral drugs into chicken, prompting a temporary crisis in consumer confidence. Yum responded by ending some supply relationships and announcing improved oversight measures.

While the safety issues were isolated to a number of farms at one end of the supply chain rather than involving weaknesses en route to market, they highlight the challenges faced even by well-established players. Past scandals have made Chinese consumers sensitive about food quality and safety: providing both is a value-add. Just as a number of private equity firms have used this as a thesis for investments in dairy supply, it also applies to cold chain logistics.

"We are concerned that in recent years China has faced a lot of problems in terms of food safety and quality," says Lanchun Duan, a partner at Cathay Capital. "One of the reasons is that China lacks professional cold chain logistics services. In developed countries almost 100% of fresh food and beverages is distributed through cold chain logistics but in China it is only 15-20%."

About one year ago, Cathay acquired a minority interest in ZM Logistics, a third-party cold chain logistics provider focused in the Yangtze River Delta area. The private equity firm is helping ZM built out temperature-controlled warehouses in all major cities in China. Duan notes that although the company is not particularly big, it is far larger than most of its competitors - ZM generates several hundred million renminbi in annual sales versus an industry average of less than RMB100 million ($16.2 million).

In China's highly-fragmented food supply networks, many suppliers don't bother with cold chain logistics at all. There is plenty of anecdotal evidence of fresh produce being delivered unchilled in cars or lorries being loaded with ice in - often futile - attempts to keep goods cold on long-haul journeys. Mark Millar, managing partner of logistics consultancy M Power Associates, estimates that anything up to one third of fresh produce in China goes to waste due to supply chain inefficiency.

This is the reason why Yum has developed in-house competencies and other multinationals have either followed suit or developed strong third-party relationships, often with foreign providers. McDonald's, for example, works with Havi Logistics, while global leaders such as Americold, Swire Cold Chain Logistics and Preferred Freezer Services are also present.

The domestic industry is expected to play catch-up, it is just a question of how long this will take. According to consultancy Roland Berger, China's cold chain logistics industry will grow at an average annual rate of 25% through 2017, by which point it will be worth RMB470 billion. Agricultural products will remain the main category, but consumption channels are evolving, with the B2B business increasingly complemented by e-commerce-enabled B2C demand. Roland Berger estimates that RMB400 million in products requiring cold chain logistics were purchased online in 2012.

Earlier this year, Hong Kong-based boutique investor EmergeVest bought a controlling stake in NFT, the UK's leading chilled food distributor. The company currently has no business in China, but Heath Zarin, managing director at EmergeVest, expects this to change, but it is unlikely to involve launching fleets of trucks and setting up warehouses. Rather, NFT is seeking to partner with domestic logistics providers and share its IT and systems expertise.
"NFT uses RedPrairie, which is regarded as one of the leading warehouse management systems, but you can't just buy it and use it, you need to have people trained in using it," Zarin says. "Often companies bring in enterprise software and they don't use it to its full capabilities. There is a lot of knowhow in terms of how you use hardware and software, operate a trucking network and feed that into a warehousing network."

Patience required

Cold chain providers tend to operate on thin net profit margins, which makes efficiency and innovation incredibly important - from offering supply chain transparency to different zones of temperature control within a warehouse. However, it is unclear whether the mass market is ready to pay a premium for these services. Despite recent progress, M Power's Millar says "the critical mass of demand coupled with the ability and the intent to pay for that additional value I don't think is there yet."

The situation is complicated by government input and industry structure. Although a still relatively low proportion of Chinese consumers are willing or able to pay more for high-end supermarket fare, foreign and some domestic brands are under pressure from both shareholders and the authorities to operate chilled supply chains, almost regardless of cost. This should create more openings for third-party providers but Simon Pearson, a China-based supply chain consultant who previously worked at NFT and Asda Walmart, says fresh produce is currently the only segment capable of delivering the scale and economics of business required. Meat and dairy are increasingly dominated by integrated players.

"The market feels very much to me like the UK in the 1980s just before the boom years of the 1990s in terms of the demand for and the development and growth of retailer-driven centralized distribution channels and chilled logistics services as well as that of specialist providers like NFT who themselves grew out a food manufacturing business," Pearson adds.

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• Topics
• Greater China
• Consumer
• China
• Cathay Capital Private Equity
• Agriculture
• Consumer